Interpreting Financial Ratio actually use simple logic just like understanding fractions. Financial Ratio is usually derived from 2 factors. The first is usually in the top of the fraction called Numerator. The second is usually in the bottom of the fraction called Lower Denominator. A simple way on how to interpret Financial Ratio:
- Anytime you see Financial Ratio called “X” O “Y” (meaning “X” over “Y”), know that X is the numerator and Y is the lower denominator. The lower denominator is the base of the interpretation. Meaning if it is for example Return On Asset (ROA) then we are interpreting ratio of income on the relationship towards the amount of asset. It means we are understanding how big the income generated by the company or the business compared to the size of asset that is invested in the business process or the company. In short, in calculating financial ratio we are deriving the relationship between the numerator and the lower denominator.
- Define each of the numerator factor and the lower denominator factor so that you will clearly understand what the factor function and definition.
- Understand that the result could be a whole number (with decimal) positive and negative, but it also can be presented in terms of percentage as well. For example: Let’s take Quick Ratio. Quick Ratio equals to Current Assets divided by Current Liabilities. Here, the numerator is Current Asset whereas the lower denominator is Current Liability. Quick Ratio shows how fast the short term asset can be to cover or pay back short term liability if needed. In other words this ratio shows the company’s liquidity. The bigger the Asset, the more liquid the business can cover its Liability.
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